Why Did Integrated Financial Firms Not Exit when Prices of Housing Started to Fall?

The crisis that eventually exploded in the fall of 2008 was several years in the making. The second half of 2005 augured trouble in the real estate market as housing prices started to decline, delinquency rates rose steeply, foreclosures experienced an uptick, and several home builders went out of business.

In the past, predicting what investment banks would do at this stage of the housing cycle used to be simple. Having ramped up the business while the going was good, they would then shutter it at the first sign of trouble. That's what happened with the mortgage conduit business in the 1980s, and again in the early 1990s. This time, it's different. Wall Street seems to have thrown out its old and trusty playbook. Instead of pulling back in 2006, several major firms went on a spending spree. That might sound strange to some. Buying at the start of downturn surely risks overpaying for an asset whose business is in decline. So why do it? Well, despite the gloomy outlook, competition is not letting up. First, clients [of investment banks] have been setting up capital-markets desks to securitize their own loans in their own version of vertical integration. Countrywide is the most renowned for doing this, but others from SunTrust to IndyMac have taken the plunge, and still others are following. Second, more players are trying to buy loans that are still for sale.

go, and that, of course, can undermine the economics of a securitization. It also means a desk has more chance of not getting enough loans in a timely manner.”

The broad implication of this is that the vertical integration of MBS and CDO production that financial firms built to maximize their nonconventional busi­ness locked them into the business and rendered executives less responsive to signs of impending trouble. Even at JPMorgan Chase, which adopted a relatively cautious MBS strategy and was a laggard in terms of vertical integration, Gil­lian Tett documents reluctance among top executives to “‘shut the spigots' of the nascent mortgage pipeline they had worked so hard to build once subprime defaults began to rise” (2009: 123-124). Failure to continue acquiring even highly risky mortgages would mean choking off tightly coupled revenue streams, which for many integrated firms had become the largest chunk of their business. Banks were making money off of origination, securitization, and borrowing money in the ABCP market to fund and hold on to high-yielding securities. Stopping any part of this process meant that profits, which had soared from 2001 to 2005, would be threatened. The natural human tendency to think that the worse could not happen took over. Everyone thought they would hunker down and be the last firm standing. It turns out that they were all wrong.